Regardless of where you live, how much you earn or what type of house you are shopping for, as soon as you find out how much the seller is asking, your first reaction might be something like, “Wow! That's expensive!” Your initial assessment is correct. With prices rising quickly, particularly in areas like New York and Boston, even starter homes can carry hefty six-figure price tags. Your next reaction is likely to be, “Can I afford that?”
Generally speaking, most prospective homeowners can afford to mortgage a property that costs between 2 and 2.5 times their gross income. Under this formula, a person earning $100,000 per year can afford to mortgage between $200,000 and $250,000. But this calculation is only a general guideline.
Ultimately, when deciding on a property, you need to consider a few more factors. First, it's a good idea to have an understanding of what your lender thinks you can afford - to gain a precise idea of what size of mortgage their clients can handle, lenders use formulas that are much more complex and thorough. Secondly, you need to determine some personal criteria by evaluating not only your finances but also your preferences.
Lender's Criteria: Debt-to-Income Ratios From a lender's perspective, your ability to purchase a home depends largely on the following factors:
Front-End Ratio
The front-end ratio is the percentage of your yearly gross income dedicated toward paying your mortgage each month. Your mortgage payment consists of four components: principal, interest, taxes and insurance (often collectively referred to as PITI) (see Understanding the Mortgage Payment Structure). A good rule of thumb is that PITI should not exceed 28% of your gross income. However, many lenders let borrowers exceed 30%, and some even let borrowers exceed 40%.
Back-End Ratio
The back-end ratio, also known as the debt-to-income ratio, calculates the percentage of your gross income required to cover your debts. Debts include your mortgage, credit-card payments, child support and other loan payments. Most lenders recommend that your debt-to-income ratio does not exceed 36% of your gross income. To calculate your maximum monthly debt based on this ratio, multiply your gross income by 0.36 and divide by 12. For example, if you earn $100,000 per year, your maximum monthly debt expenses should not exceed $3,000.
Down Payment
A down payment of at least 20% of the purchase price of the home minimizes insurance requirements, but many lenders let buyers purchase a home with significantly smaller down payments. The down payment has a direct impact on your mortgage payment and therefore also on both the front-end and back-end ratios. Larger down payments enable buyers to purchase more expensive homes.
Being House Poor: a Personal Decision To be '
house poor' means that the costs of paying for and maintaining your home take up such a large percentage of your income that you don't have enough money left to cover other expenses. As grim as that sounds, many people choose to be house poor because they believe that it's wise to purchase the most expensive home that they can afford, regardless of how far they have to stretch. Their theory is that, over time, their income will increase as a result of raises and promotions, making that expensive mortgage a smaller and smaller percentage of their monthly expenses.
Clearly, those who choose to be house poor have their own set personal criteria determining what kind of home they can afford. (To learn more about the home costs, see
To Rent or Buy? The Financial Issues - Part 1,
Home-Equity Loans: The Costs and
The Home-Equity Loan: What It Is And How It Works.)
Personal Criteria The decision of whether or not to be house poor is largely a matter of personal choice - since getting approved for a mortgage doesn't mean that you can actually afford the payments. So in addition to the lender's criteria, consider the following issues and set some decisive factors of your own:
Income
When contemplating your ability to pay a mortgage, ask yourself the following questions: Are you relying on two incomes just to pay the bills? Is your job stable? Can you easily find another job that pays the same or better wages if you should lose your current job?
Expenses
The calculation of your back-end-ratio will include most of your current debt expenses, but what about other expenses that you haven't generated yet? Will you have kids in college someday? Do you have plans to buy a new car, truck or boat? Does your family enjoy a yearly vacation?
Lifestyle
Are you willing to change your lifestyle to get the house you want? If fewer trips to the mall and a little tightening of the budget don't bother you, applying a higher back-end-ratio might work out fine. If you can't live without that double mocha cappuccino every morning, you might want to play it safe and take a more conservative approach to that mortgage payment.
Personality
No two people have the same personality, regardless of their income. Some people can sleep soundly at night knowing that they owe $5,000 per month for the next 30 years, while others fret over a payment half that size. The prospect of refinancing the house in order to afford payments on a new car would drive some people crazy while not worrying others at all. If you keep your personality in mind when shopping for a new house, you are likely to be pleased with your purchase.
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